Thoughts About A Handful Of mREITs And The State Of The Industry (Week 17)

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Includes: AGNC, AI, AMTG, ANH, ARR, BXMT, CHMI, CIM, CMO, CYS, DX, EARN, JMI, MFA, MTGE, NLY, NRZ, NYMT, ORC, STWD, TWO, WMC, ZFC
by: ColoradoWealthManagementFund

Summary

The long-term agency yields continue to decline.

The mREIT sector as a whole has seen share prices bouncing back lately to see levels similar to the start of the year.

AI reported recently and announced some changes to how it will report in 2016 that I think will improve the comparability of its metrics.

I've put together some quick thoughts on most of the mREITs.

When I started writing my "thoughts about mREITs" column, I had no idea it would grow to be such a popular series. The weekly series has helped investors stay up to date with the developments on the yield curve, know about the different factors influencing different mREITs, and given me an incentive to think about the developments in each week. To avoid having articles become too similar, I'm going to work on bringing new elements to the front each week.

The mREITs

The table is demonstrated below:

Annaly Capital Management

(NYSE:NLY)

American Capital Agency Corp.

(NASDAQ:AGNC)

ARMOUR Residential REIT

(NYSE:ARR)

Capstead Mortgage Corporation

(NYSE:CMO)

CYS Investments

(NYSE:CYS)

Dynex Capital

(NYSE:DX)

Long DX

Javelin Mortgage Investment

(NYSE:JMI)

New York Mortgage Trust

(NASDAQ:NYMT)

Orchid Island Capital

(NYSE:ORC)

Two Harbors Investment Corp.

(NYSE:TWO)

Western Asset Mortgage Capital Corp.

(NYSE:WMC)

MFA Financial

(NYSE:MFA)

Ellington Residential Mortgage REIT

(NYSE:EARN)

Arlington Asset Investment Corporation

(NYSE:AI)

Technically Corporation

ZAIS Financial

(NYSE:ZFC)

Apollo Residential Mortgage

(NYSE:AMTG)

Anworth Mortgage Asset Corporation

(NYSE:ANH)

American Capital Mortgage Investment

(NASDAQ:MTGE)

Cherry Hill Mortgage Investment

(NYSE:CHMI)

Starwood Property Trust

(NYSE:STWD)

Blackstone Mortgage Trust

(NYSE:BXMT)

Chimera Investment Corporation

(NYSE:CIM)

New Residential Investment Corp.

(NYSE:NRZ)

Click to enlarge

A Quick Note On Rate Movements

Frequently, for these articles, I would pull out some fairly large tables demonstrating interest rate movements.

Since I was catching up on the column and covered the rate movements a few days ago, I want to truncate that portion of the piece. The thing I want to emphasize is that on Dec. 31st, the 30YR FNMA 3.5 was $103.19, and today, it is $104.75. That is a fairly material movement for just over a month. The lower-rate agency MBS have performed substantially better than the higher-rate MBS due to expectations regarding prepayments.

This is only a few basis points higher than it was at the end of last week (January 29th, 2016). However, it continues a solid trend of long-term agency rates moving lower.

Individual Comments

Let's fly through several of the other mREITs on my chart.

Annaly Capital Management has a projected earnings date around February 22nd to 26th. The late report is a little interesting; given that it is one of the larger mREITs, can its performance on a quarter influence investors to buy or sell the sector? My latest piece on NLY was taking a look at the potential uses for the physical real estate in its portfolio.

American Capital Agency Corp. already declared its fourth-quarter performance, and I had a fairly lengthy analysis of its performance with link backs to other research to demonstrate the successful prediction of BV.

ARMOUR Residential REIT recently reported how it was doing in January, and the results were in line with my projections but still quite disappointing. The biggest disappointment for me was the lack of shares being repurchased during the huge selloff event in January. It was only a few hours long and most investors wouldn't be able to respond that fast. However, I would expect each mREIT to have their own portfolio being modeled in real time and to be able to rapidly respond to at least some degree to take advantage of those exceptionally low share prices.

CMO remains interesting primarily because of its low-cost operating structure. It is using adjustable rate mortgages which are fairly nice for reducing duration risk, but I'm concerned that the amortization costs necessary to deal with prepayments may encourage CMO to reduce its dividend. Prepayments are a major problem for investing in agency-adjustable-rate MBS.

CYS Investments is another low-cost leader in the agency mREIT space. I had a fairly bullish stance on it earlier, but as share prices have moved quite materially from around $6 to over $7, I'll need to put in a few hours rerunning my models and analyzing my expectations.

Dynex Capital is my personal long position in the industry. I like the way the CMBS portfolio complements the agency RMBS. I also love the internal management structure. However, it is also a potential candidate for suffering from high prepayments on adjustable-rate MBS. I'm looking for the company to be repurchasing shares whenever the discount gets materially larger than 20%, which should strengthen book value.

JMI remains in a proxy contest with Wolverine. I contacted Wolverine a while back seeking comment, but heard nothing of value. It'll be interesting to see where things go here. JMI is too small to have reasonable economies of scale on the positions and the only reasonable course of action left is liquidation or a merger with another mREIT.

NYMT remains a fairly risky mREIT due to its exposure to both prepayment risk and loss of principal through some aggressive CMBS positions. I would see the company as a potential trading investment, but I think investors must be exceptionally educated to make the moves in and out of it. I haven't done an individual coverage of NYMT since its Q3 earnings release.

The reason I don't cover NYMT more frequently is something that should be a red flag for many investors. The portfolio is so complex that living up to my own standards for analysis is exceptionally difficult. If it takes me so long to analyze the company that I often choose to just move on, investors should be sure they are confident in their own analysis. One of the problems for me in analyzing the mREITs is the impact of first loss tranches. Even if an analyst performs an absolutely exceptional analysis, if a couple of those tranches suddenly show heavy defaults, it would invalidate the entire premise of the author's work. I want to have as few major external factors as possible, and I want to have a way to model the expected impact of each factor.

Orchid Island Capital is back to just under $9. Its relative pricing seems acceptable but not great. Remember that my opinion on ORC is constantly tied to the relative discounts to book value. I've regularly held myself out of positions in ORC, but I think it has been one of the easier mREITs for me to identify prices that are too low or too high, which makes me consider doing some trading later in 2016.

Western Asset Mortgage Capital sees some fairly inefficient pricing as well, but it has been more resilient against corrections, and it seems more difficult to identify solid "buy" points than solid "sell" points.

Arlington Asset Investment Corporation recently reported earnings. I've been meaning to prepare a short article discussing its performance for the quarter, but it was strange enough that I haven't got it done yet. It has a fairly large dividend and still reported a material gain in book value for the quarter. I previously built it into my custom models for estimating book value, but managed to lose all of the data in a crash. It takes quite a while to build the models for each mREIT.

I do want to give the company props for announcing in its press release and on the earnings call that it would be changing its accounting systems in 2016. The new system will more closely resemble the suggestions I made. The result should be more efficient pricing for the company. One of the challenges I will continue to have in assessing it is determining how to handle its prepaid tax asset. An mREIT wouldn't need that asset, but the corporate structure (with the prepaid tax asset) does offer some taxation benefits. If you think it might be a good fit for you, see a tax accountant. I work on numbers for comparable value, I don't help with taxes.

Starwood Property Trust is an interesting option, but it is one I'm not big on trading. It provides some excellent information to investors, but I prefer simpler options. An investor either needs to be downright exceptional to trade in the security, or they need to be confident in the management and willing to commit to a simple buy-and-hold strategy.

MFA Financial may warrant further inspection. I've covered the mREIT a few times, but I prefer to cover them where the discount to book value is larger. MFA's Q3 book value was $7.70. The latest price of $6.41 is only about a 17% discount to that value. Since Q4 saw most mREITs losing book value, the relatively small discount to last reported book value concerns me.

American Capital Mortgage Investment needs a good way to sell off its MSR position. It doesn't have the economies of scale necessary to make money on the position. The fair value adjustments on MSRs can provide negative duration, but how valuable is a segment that simply loses money each quarter? If MTGE came up with a plan to sell off these assets and get anything near book value, I think shares would rally quickly.

Blackstone Mortgage Trust fell so hard in January I had to start contemplating a position. Ultimately, I decided against it. When I researched the shares before, I felt a bit uneasy. I've started to listen to that feeling more. Its portfolio has some very appealing characteristics, but I'm not venturing that far into credit-sensitive assets.

Conclusion

Share prices have been rebounding across the sector. A few mREITs have reported earnings, and so far, the results haven't been too bad. AGNC came in very close to projections, and AI made some great movements to increase its transparency. I believe the most reasonable interest rate scenario is "lower for longer", but volatility encourages prepayments, and there is a potential for a flatter yield curve if the Federal Reserve decides to raise its short-term target rates. As prices are climbing, I'm seeing fewer opportunities where I think investors can enter into a position with a margin of safety.

I've been interested in a few mREITs for potential liquidation plays, but there is still a material risk that such an event won't come to pass. If the mREITs are convinced they can reduce hedges to drive up their net interest income after hedging costs, the movement towards a smaller discount to book value could be sustainable. I'm not convinced yet and would rather wait and look for short-term market failures.

Disclosure: I am/we are long DX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.